Stunning Shortsightedness in Europe

The International Monetary Fund has just slashed its 2012 estimate for economic growth in Eastern Europe by 60%, with the target now standing at 1.1% -- down from the prior 2.7% forecast just four months ago. This has occurred in tandem with a wave of downgrades and expressions of concern about the contagion impact of the euro crisis on peripheral regional countries on the part of the World Bank, The European Investment Bank, the European Bank for Reconstruction and Development and every major money center in the world.

The Western European money centers, which supply the vast majority of funding to the Eastern members, have been withdrawing their capital in an attempt to maintain capital solvency for the core portfolio of loans in the West. Apparently, the latter has had an epiphany regarding the impact of the European crisis on Eastern member states -- and it appears to have been triggered by Hungary's recent push-back against the European Union, the euro and the IMF.

More specifically, Hungary recently altered its constitution to allow the federal government to have a more active role in the management of its central bank and monetary policy. These are actions that the global proponents of "independent central banking" find abhorrent. A global media campaign to demonize the Hungarian government has developed in response.

None of this was unforeseen. The potential for all of these actions was telegraphed and obvious for anyone willing to simply look at what was transpiring in Europe. For example, I wrote about the inevitability of this two years ago, and again last summer. This past November, as Mario Draghi took over the European Central Bank, I discussed it again. In that last column, as well, I concluded with what the corrective action necessary was to maintain Eastern member states in the EU and preclude them from leaving: a depreciated euro.

My point here is not to say, "I told you so," or to pat myself on the back for having properly foreseen these issues. The point is that they have been obvious for years now. It raises the question of why the banks, governments and intergovernmental organizations have been consistently caught unawares in their reactions to these situations. It is a perplexing question, and one to which I do not know the answer.

What is as obvious as the inevitability of these issues, however, is the counterproductive response to them by these same organizations. The IMF, Bundesbank, and ECB are advocating fiscal austerity measures for the Western EU states while precluding the monetary stimulus that's necessary to making those actions possible.

In other words, Europe's leaders have shown a profound failure to distinguish between long-term goals and immediate needs. The viability of the euro and the EU requires immediate euro depreciation. Although Mr. Draghi has clearly signaled a willingness to provide this, it still isn't forthcoming.

Along with this, those in power have also collectively failed to understand how close the EU is to disintegration. If substantive action is not taken very soon, member states will have to leave the euro and the union in order to survive.

The World Economic Forum begins its five-day meeting in Davos, Switzerland starting Wednesday -- and, in my opinion, this will be the most important in their history. The views expressed here concerning the European situation and how to address it, as well as the reception of those views, will act as a guide for how the governments of the Eastern EU members should proceed.

As for how this all has played out in the equities markets, over the past few days investors have expressed optimism regarding the actions set to be taken in Europe soon, and which have been driving up bank stock prices there. In the last two weeks, Deutsche Bank (DB) shares have risen 34%, UBS (UBS) is up 18%, and BNP Paribas has climbed 28%. Italy's Unicredit, meanwhile, has surged on renewed expectations that it will be able to raise capital.

But the economic backdrop in Europe does not warrant any of this optimism. Withholding necessary monetary stimulus, while simultaneously attempting to enforce fiscal austerity, is a prescription for disaster. Europe's accelerating decline in economic activity is bound to generate even greater problems in attempts to hold the union together in the immediate future. When Greece defaults or Hungary withdraws, or some other similarly disastrous event occurs, you can be sure the authority figures there will be expressing shock.